Gareth Parker of Russell Indexes discusses small cap indices, the importance of index construction for investors and the limitations of the S&P 500.

As passive investment via products such as exchange-traded funds (ETFs) becomes more popular, questions around index construction are likely to gain more investor attention. Gareth Parker, senior director, index research, design and development, EMEA, Russell Indexes looks at the importance of selecting the right index to get the intended exposure you seek.

If you take the ten most popular US equity indices, as measured by the assets benchmarked against them, nine are from Russell (Russell US Institutional Benchmark Survey, December 2013). These include the large-cap Russell 1000® Index, which covers about 91% of the US equity market capitalisation, and the Russell 2000® Index, the popular US small-cap benchmark, which covers the next 8% of US stocks by market capitalisation. The firm also offers the Russell 3000® Index, which combines the two to cover the largest 3,000 US stocks.

It is perhaps the small-cap index which is the most well-known. For more than 30 years, academics have noted and discussed the performance premium that has historically come from investing in small companies – as smaller firms have had higher risk-adjusted returns, on average, than larger firms.

Those investors who want to realise this small-cap premium often turn to the US equity market, for good reason.

The Russell 2000® Index represents 49% of the global small-cap equity market – a reflection of the relative dominance of the US equity market. By buying the index with a single trade – through an ETF such as the SPDR Russell 2000 ETF from State Street, for instance – a European investor can immediately get access to half the world’s small-cap companies by market cap.

There are other reasons for choosing small-caps beyond the historical performance premium.

“Small caps are a good way to get proper country exposure, the largest companies tend to be global mega caps, not a good representative of the country they happen to be listed in,” says Parker.

Given all the benefits of small-cap investing, it may come as a surprise that the Russell 2000 Index has lagged behind the performance of the large-cap index this year. By mid-October, the Russell 2000 was down nearly 9%, whereas the Russell 1000 was up more than 4%. The Russell 3000, which combines the two, was up 3%.

Parker notes that, “unsurprisingly, the lagging performance has meant the Russell 2000 has attracted less investor interest than in previous years, though there has been demand from investors who want to make a contrarian trade and bet that the relative performance of the small and large-cap indices could soon reverse”.

This could well happen. What’s interesting about the Russell 1000 and 2000 is that their correlation can be as low as 60% at times (Bloomberg, 30th September, 2014), which is about the correlation of the German stock market compared to the US. This means the indices often diverge, one gaining while the other falls (as has happened this year). This also means one index may be used as a hedge for the other and that, when one when index is far ahead, it may be time to invest in the opposite trade. As Parker explains, “there have been a lot of buying opportunities in the small-cap sector this year”.

If investors do decide that now is a good time to buy tracker funds based on the Russell 2000, one aspect they need to consider is how the index will combine with their existing US equity exposure. If the investor already owns tracker funds based on the Russell 1000, adding the Russell 2000 will give comprehensive exposure to about 99% of the US stock market.

If, however, an investor is exposed to US large-cap equities via the S&P 500® Index, it will not be so simple to add the Russell 2000 and therefore gain comprehensive coverage.

The reason is that the S&P 500 is not constructed in the same way as the Russell Indexes. Whereas the comprehensive and modular construction of the Russell 1000, 2000 and 3000 is very similar to that taken by FTSE in the UK, the S&P 500 is a sampled index that is constructed by a committee. In order to maintain the right sector balance in the index, the committee may sometimes exclude some large stocks. This is one reason why the S&P index only contains 500 constituents whereas the Russell large-cap index contains 1000.

A problem can arise for investors who have exposure to the S&P 500 and want to add small-cap exposure with the Russell 2000. The investor may assume they would end up with comprehensive coverage of the US stock market but in fact there would be gaps and overlaps in cap size coverage as the S&P 500’s coverage extends from the top of the US market down to around the 1100-ranked company.

“Because of the specific methodology of the S&P 500, it’s difficult to move to a broad exposure by adding something to the S&P 500”, says Parker.

Investors could, of course, buy funds that track the Russell 1000 and combine it with the Russell 2000, or they could invest straight into the Russell 3000, an avenue now available through products such as the SPDR Russell 3000 ETF.

Parker says “the S&P 500 does a good job – its performance is usually similar to the Russell 1000, although the holdings are different” – yet he questions whether its construction is the ideal approach, suggesting that the committee system is “anachronistic”. The Russell Indexes aim simply to represent the market – they have a clear and transparent methodology, without committees and seem to be in tune with investors’ needs.

“People like the Russell index approach for its total transparency,” he says.

“Everyone knows what the index will do, what will get added what will be deleted. With the S&P 500 you have to wait until the committee says.”

Russell Investments is a Washington, USA Corporation which operates through subsidiaries worldwideand is a subsidiary of The Northwestern Mutual Life Insurance Company. Russell Investments is the owner of the trademarks, service marks and copyrights related to its respective indices. Indices are unmanaged and cannot be invested in directly. Returns represent past performance, are not aguarantee of future performance and are not indicative of any specific investment. This material is proprietary and may not be reproduced, transferred or distributed in any form without prior written permission from Russell Investments. It is delivered on an ‘as is’ basis without warranty. This is not an offer, solicitation or recommendation to purchase any security or the services of any organisation.

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